How is Debt a Good Thing?

  • Edge Editorial Team

    At Edge Investments, we make investing in small cap stocks enjoyable and edge-ucational. We are here to teach you about investing, keep you up to date on news, and help connect you with companies that you may have a desire to invest in.

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Debt is a big, scary word for most people; however, whether you’re an individual or a company, fearing debt is one of the best ways to close yourself off from opportunity. ⁠ 

If you think about someone who owns a house, you don’t typically think “wow, they have a lot of debt!”; you’re more likely going to think “wow, they own something valuable!”. But of course, most people don’t have enough money to purchase a home outright – they use a mortgage. ⁠ 

The age-old adage that you have to spend money to make money” isn’t reserved for those that already come from riches. Finding new ways to access capital is key to attaining the leverage necessary to make real money in any venturethe saying is common because, realistically, you can’t scale and accomplish things without adequate resources. 

A lot of conservative thinkers have an issue understanding the true value of money, as they want to keep their risk as minimal as possible; however, it would be foolish to consider all debt a bad thing. 

Let’s look at this from both sides of the boardroom: as an individual and as a company. 

Debt for Individuals 

The mortgage example is a good one, as it’s one of the most common uses of debt in most peoples’ livesA mortgage is a loan, aka debt, that allows you to purchase an asset that will increase in value over time. In case you’re a bit younger and reading this while thinking that home ownership is still a bit out of reach, we’ll use an example that could hit a bit closer to home: student loans. 

For many students, their families can’t afford to pay for their post-secondary schooling outright, so they apply to the government for loans. These are typically granted at extremely low (or nonexistent) interest rates to allow the student to build up their professional competencies and land themselves a higher paying job. The student loans, aka debt, are building you up as the asset, which is increasing exponentially in value. 

Of course, there’s a debate surrounding the efficacy of post-secondary schooling in general… but that’s beside the point. 

If you’re taking on debt in order to make investments that will benefit you in the futureyou’ve taken on good debt. 

We can also look at debt from a purely financial perspective and consider the time value of money. If you borrow $10,000 today and agree to pay 3% compounding interest on it over 10 yearsyou’ve agreed to pay the lender back roughly $13,500 for access to that capital. If you take the money and put it into investments that are returning a compound 7% interest over that same time period, then that $10,000 will transform into just over $20,000. Yes, you are taking on a bit more risk by having an obligation to pay someone back, but you’re also earning $6,500 that you wouldn’t otherwise be able to earn. 

Bad debt, on the other hand, is when people get ahead of themselves and live beyond their means. Spending on your credit card when you really can’t afford to, taking on debt that you aren’t planning to pay back, and general carelessnessAll these things create bad debt. ⁠ 

For the financially frugal among us, this may be old news… but what about classifying debt that a company has taken on? 

Debt for Companies 

Why is it so common for companies to have debt? Why not issue equity until you are on solid enough footing to become self-sustaining, then let retained earnings provide you with the cash you need to grow? 

The first (and most obvious) reason is: this isn’t realistic if you want to grow quicklyEven the most successful early-stage companies eventually come up to a financial hurdle that overshadows their current monetary capabilities. In order to make the jump from big fish, small pond to the next level, they have to introduce additional financing to their operations. 

The second reason? Equity is extremely expensive; however, when you’re early on in your business, it’s often the only option. Try to imagine approaching the bank with nothing but a dollar and a dream to ask for cash to turn it into a real business… they’d tell you to come back when you have something real to show them. After all, institutional lending is a risk equation: if they have sufficient evidence to believe in a company’s growth, then they can be reasonably assured that the company will be able to return X% of the money each period. If not? They can’t take that risk.  

Early-stage equity investors get in with such attractive valuations because they’re taking on a lot of risk by putting their money behind that dollar and a dream; however, as mentioned, it’s extremely expensive for a company to continuously issue equity. Think of it this way: you can get a loan for $10M and, at the end of the loan, pay back a collective $12M, or you can issue $10M worth of equity and have to pay back nothing… but if your company grows as you think it will, that $10M could be worth $100M one dayA steep price to pay for access to capital. As soon as a company can prove that they’re stable enough to pay back debt on an expected schedule, they can start bringing down the true cost of their financed dollars. 

But wait, there’s a secret formula here! There’s an equation to find out the sweet spot for companies, allowing them to benefit from both options while paying the lowest possible price. This is found by determining the weighted average cost of capital (WACCand ensuring that you’re staying within what we’ll call the Golden Zone. 

WACC & the Golden Zone 

Weighted average cost of capital is the proportionate price that you’re paying for money, aka, what you owe for each dollar you financeHere is the associated equation: 

If you’re a bit worried that we’re entering fundamental analysis territory, have no fear, the teaching team is here. Trust us, this is a relatively simple concept as soon as you break through the acronyms and equations.  

The first thing to determine is cost of equity (Re– this is a moving target determined by the relationship between a company and its shareholders. It’s the return that a shareholder expects from their piece of the company and, if not met, will result in the shareholder selling their ownership. In theory, this will result in the company’s stock price going down, which no one wants. A purely theoretical figure, however, if you know that your shareholders are expecting a 7% return (aka the average cost of equity within U.S. markets), then you, as the company, are aiming to increase the value of your company by at least 7% annually to satisfy investors. 

The rest of the pieces are easier to understand: 

Cost of debt (Rd) – how much the company is paying in interest for a loan. 

– Market value of the company’s equity. 

D – Market value of the company’s debt. 

V – Total market value of the company’s equity and debt. 

Tc – Corporate tax rate (15% in Canada and 21% in the U.S.). 

Once you’ve laid out all the pieces, you can calculate the WACC and determine if the company is near, below, or above the Golden Zone. This is the point in which a company has paid the least amount of interest possible for all of its financed dollars, while ensuring that investors can properly evaluate the return that they’re to expect out of a company. This concept is also sometimes called the optimum capital structure… but we prefer Golden Zone, as it helps to get the message of a Win-Win across a bit more visually. 

If WACC is extremely low, then it means that you could probably serve to take on more aggressive financing, as investors will remain pleased with lower relative returns while you grow the company. With a low WACC, you’ll likely be more open to equity issues. On the other hand, an extremely high WACC could result in a company unable to attract new investments, as there will be less explosive growth potential for investors at that point. With a high WACC, you’ll likely want to pursue debt financing. 

On Debt 

Hopefully, after reading, you see the value that debt can have for individuals and businesses, and the interrelationships between different forms of financing. We also hope that you no longer see debt as the bogeyman 

It all boils down to assessing risk versus reward and seeing what will benefit you in the long-term – you can’t control money if you’re afraid of it! 

  • Edge Editorial Team

    At Edge Investments, we make investing in small cap stocks enjoyable and edge-ucational. We are here to teach you about investing, keep you up to date on news, and help connect you with companies that you may have a desire to invest in.

    View all posts

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